Problem Session-2

ECO102
Principles of
Macroeconomics
Problem Session-3
by
Research Assistant
Serkan Değirmenci
29.03.2012
Today
• Mankiw (2008), Principles of Economics:
- Chapter 29: The Monetary System:
 Questions for Review: 1-2-3-4-5-6-7-8-9 (page: 660)
 Problems and Applications: 2-3-4-5-6-7-8-9-10-11-12-13
(page: 660-661)
- Chapter 30: Money Growth and Inflation:
 Questions for Review: 1-2-3-6-7 (page: 685)
 Problems and Applications: 1-2-3-5-6-9-10-11-12 (page: 686687)
Chapter 29: QfR-1 (page: 660)
• What distinguishes money from other assets
in the economy?
ANSWER: (PAGE: 643)
Money is different from other assets in the
economy because it is the most liquid asset
available.
Other assets vary widely in their liquidity.
Chapter 29: QfR-2 (page: 660)
• What is commodity money? What is fiat money? Which kind
do we use?
• ANSWER: (PAGE: 643-645)
Commodity money is money with intrinsic value, like gold,
which can be used for purposes other than as a medium of
exchange.
Fiat money is money without intrinsic value; it has no value
other than its use as a medium of exchange.
Our economy today uses fiat money.
*the term instrictic value means that the item would have value
even if it were not used as money.
Chapter 29: QfR-3 (page: 660)
• What are demand deposits, and why should
they be included in the stock of money?
• ANSWER: (PAGE: 646)
Demand deposits are balances in bank
accounts that depositors can access on
demand simply by writing a check. They
should be included in the supply of money
because they can be used as a medium of
exchange.
Chapter 29: QfR-4 (page: 660)
• Who is responsible for setting monetary policy in the United
States? How is this group chosen?
• ANSWER: (PAGE: 648-649)
The Federal Open Market Committee (FOMC) is responsible
for setting monetary policy in the United States.
The FOMC consists of the 7 members of the Federal Reserve
Board of Governors and 5 of the 12 presidents of Federal
Reserve Banks.
Members of the Board of Governors are appointed by the
president of the United States and confirmed by the U.S.
Senate.
The presidents of the Federal Reserve Banks are chosen by
each bank’s board of directors.
Chapter 29: QfR-5 (page: 660)
• If the Fed wants to increase the money supply with
open-market operations, what does it do?
• ANSWER: (PAGE: 653)
If the Fed wants to increase the supply of money
with open-market operations, it purchases U.S.
government bonds from the public on the open
market.
The purchase increases the number of dollars in the
hands of the public, thus raising the money supply.
Chapter 29: QfR-6 (page: 660)
• Why don’t banks hold 100 percent reserves? How is the
amount of reserves banks hold related to the amount of
money the banking system creates?
• ANSWER: (PAGE: 650-651-653-653)
Banks do not hold 100% reserves because it is more
profitable to use the reserves to make loans, which earn
interest, instead of leaving the money as reserves, which
earn no interest.
The amount of reserves banks hold is related to the amount
of money the banking system creates through the money
multiplier. The smaller the fraction of reserves banks hold,
the larger the money multiplier, because each dollar of
reserves is used to create more money.
Chapter 29: QfR-7 (page: 660)
• What is the discount rate? What happens to
the money supply when the Fed raises the
discount rate?
• ANSWER: (PAGE: 655-656)
The discount rate is the interest rate on loans
that the Federal Reserve makes to banks.
If the Fed raises the discount rate, fewer
banks will borrow from the Fed, so both
banks' reserves and the money supply will be
lower.
Chapter 29: QfR-8 (page: 660)
• What are reserve requirements? What
happens to the money supply when the Fed
raises reserve requirements?
• ANSWER: (PAGE: 654)
Reserve requirements are regulations on the
minimum amount of reserves that banks must
hold against deposits.
An increase in reserve requirements raises
the reserve ratio, lowers the money
multiplier, and decreases the money supply.
Chapter 29: QfR-9 (page: 660)
• Why can’t the Fed control the money supply perfectly?
• ANSWER: (PAGE: 656)
The Fed cannot control the money supply perfectly
because:
(1) the Fed does not control the amount of money that
households choose to hold as deposits in banks; and
(2) the Fed does not control the amount that bankers
choose to lend.
The actions of households and banks affect the money
supply in ways the Fed cannot perfectly control or
predict.
Chapter 29: P&A-2 (page: 660)
Which of the following are money in the U.S. economy?
Which are not? Explain your answers by discussing each of the three functions
of money.
a. a U.S. penny
b. a Mexican peso
c. a Picasso painting
d. a plastic credit card
ANSWER:
a. A U.S. penny is money in the U.S. economy because it is used as a medium of exchange to
buy goods or services, it serves as a unit of account because prices in stores are listed in
terms of dollars and cents, and it serves as a store of value for anyone who holds it over
time.
b. A Mexican peso is not money in the U.S. economy, because it is not used as a medium of
exchange, and prices are not given in terms of pesos, so it is not a unit of account. It could
serve as a store of value, though.
c. A Picasso painting is not money, because you cannot exchange it for goods or services, and
prices are not given in terms of Picasso paintings. It does, however, serve as a store of value.
d. A plastic credit card is similar to money, but represents deferred payment rather than
immediate payment. So credit cards do not fully represent the medium of exchange
function of money, nor are they really stores of value, because they represent short-term
loans rather than being an asset like currency.
Chapter 29: P&A-3 (page: 660)
What characteristics of an asset make it useful as a medium of exchange?
As a store of value?
ANSWER:
• For an asset to be useful as a medium of exchange, it must be widely
accepted (so all transactions can be made in terms of it), recognized easily
as money (so people can perform transactions easily and quickly),
divisible (so people can provide change), and difficult to counterfeit (so
people will not print their own money). That is why nearly all countries
use paper money with fancy designs for larger denominations and coins
for smaller denominations.
• For an asset to be useful as a store of value, it must be something that
maintains its value over time and something that can be used directly to
buy goods and services or sold when money is needed. In addition to
currency, financial assets (like stocks and bonds) and physical assets (like
real estate and art) make good stores of value.
Chapter 29: P&A-4 (page: 660)
Your uncle repays a $100 loan from Tenth National Bank by writing a $100 check
from his TNB checking account. Use T-accounts to show the effect of this
transaction on your uncle and on TNB. Has your uncle’s wealth changed? Explain.
ANSWER:
When your uncle repays a $100 loan from Tenth National Bank (TNB) by writing a
check from his TNB checking account, the result is a change in the assets and
liabilities of both your uncle and TNB, as shown in these T-accounts:
Your Uncle
Assets
Before:
Checking Account
After:
Checking Account
Before:
Loans
After:
Loans
Assets
Liabilities
$100 Loans
$100
$0 Loans
$0
Tenth National Bank
Liabilities
$100 Deposits
$100
$0 Deposits
$0
By paying off the loan, your uncle simply eliminated the outstanding loan using
the assets in his checking account. Your uncle's wealth has not changed; he simply
has fewer assets and fewer liabilities.
Chapter 29: P&A-5 (page: 660)
Beleaguered State Bank (BSB) holds $250 million in
deposits and maintains a reserve ratio of 10 percent.
a. Show a T-account for BSB.
b. Now suppose that BSB’s largest depositor withdraws
$10 million in cash from her account. If BSB decides to
restore its reserve ratio by reducing the amount of
loans outstanding, show its new T-account.
c. Explain what effect BSB’s action will have on other
banks.
d. Why might it be difficult for BSB to take the action
described in part (b)? Discuss another way for BSB to
return to its original reserve ratio.
Chapter 29: P&A-5 (page: 660)-cont.
ANSWER:
a. Here is BSB's T-account:
Beleaguered State Bank
Assets
Reserves
Loans
Liabilities
$25 million Deposits
$225 million
$250 million
b. When BSB's largest depositor withdraws $10 million in cash and BSB reduces its
loans outstanding to maintain the same reserve ratio, its T-account is now:
Beleaguered State Bank
Assets
Reserves
Loans
Liabilities
$24 million Deposits
$216 million
$240 million
c. Because BSB is cutting back on its loans, other banks will find themselves short of
reserves and they may also cut back on their loans as well.
d. BSB may find it difficult to cut back on its loans immediately, because it cannot
force people to pay off loans. Instead, it can stop making new loans. But for a time it
might find itself with more loans than it wants. It could try to attract additional
deposits to get additional reserves, or borrow from another bank or from the Fed.
Chapter 29: P&A-6 (page: 660)
• You take $100 you had kept under your mattress and deposit
it in your bank account. If this $100 stays in the banking
system as reserves and if banks hold reserves equal to 10
percent of deposits, by how much does the total amount of
deposits in the banking system increase? By how much does
the money supply increase?
ANSWER:
If you take $100 that you held as currency and put it into the
banking system, then the total amount of deposits in the
banking system increases by $1,000, because a reserve ratio
of 10% means the money multiplier is 1/.10 = 10.
Thus, the money supply increases by $900, because deposits
increase by $1,000 but currency declines by $100.
Chapter 29: P&A-7 (page: 660)
• The Federal Reserve conducts a $10 million open-market
purchase of government bonds. If the required reserve
ratio is 10 percent, what is the largest possible increase in
the money supply that could result? Explain. What is the
smallest possible increase? Explain.
ANSWER:
With a required reserve ratio of 10%, the money multiplier
could be as high as 1/.10 = 10, if banks hold no excess
reserves and people do not keep some additional currency.
So the maximum increase in the money supply from a $10
million open-market purchase is $100 million.
The smallest possible increase is $10 million if all of the
money is held by banks as excess reserves.
Chapter 29: P&A-8 (page: 660)
Assume that the reserve requirement is 5 percent. All
other thing equal, will the money supply expand more if
the Federal Reserve buys $2000 worth of bonds or if
someone deposits in a bank $2000 that he had been
hiding in his cookie jar? If one creates more, how much
more does it create? Support your thinking.
ANSWER:
The money supply will expand more if the Fed buys
$2,000 worth of bonds.
Both deposits will lead to monetary expansion.
But the Fed’s deposit is new money. The $2,000 from
the cookie jar is already part of the money supply.
Chapter 29: P&A-9 (page: 660)
Suppose that the T-account for First National Bank is as follows:
a. If the Fed requires banks to hold 5 percent of deposits as reserves, how much in
excess reserves does First National now hold?
b. Assume that all other banks hold only the required amount of reserves. If First
National decides to reduce its reserves to only the required amount, by how much
would the economy’s money supply increase?
ANSWER:
a. If the required reserve ratio is 5%, then ABC Bank's required reserves are
$500,000 x .05 = $25,000. Because the bank’s total reserves are $100,000, it
has excess reserves of $75,000.
b. With a required reserve ratio of 5%, the money multiplier is 1/.05 = 20. If
ABC Bank lends out its excess reserves of $75,000, the money supply will
eventually increase by $75,000 x 20 = $1,500,000.
Chapter 29: P&A-10 (page: 661)
Suppose that the reserve requirement for checking deposits is 10 percent and that
banks do not hold any excess reserves.
a. If the Fed sells $1 million of government bonds, what is the effect on the
economy’s reserves and money supply?
b. Now suppose the Fed lowers the reserve requirement to 5 percent, but banks
choose to hold another 5 percent of deposits as excess reserves. Why might banks
do so? What is the overall change in the money multiplier and the money supply
as a result of these actions?
ANSWER:
a. With a required reserve ratio of 10% and no excess reserves, the money
multiplier is 1/.10 = 10. If the Fed sells $1 million of bonds, reserves will decline
by $1 million and the money supply will contract by 10 x $1 million = $10 million.
b. Banks might wish to hold excess reserves if they need to hold the reserves for
their day-to-day operations, such as paying other banks for customers'
transactions, making change, cashing paychecks, and so on.
If banks increase excess reserves such that there is no overall change in the total
reserve ratio, then the money multiplier does not change and there is no effect
on the money supply.
Chapter 29: P&A-11 (page: 661)
Assume that the banking system has total reserves of $100 billion. Assume
also that required reserves are 10 percent of checking deposits, and that
banks hold no excess reserves and households hold no currency.
a. What is the money multiplier? What is the money supply?
b. If the Fed now raises required reserves to 20 percent of deposits, what
is the change in reserves and the change in the money supply?
ANSWER:
a. With banks holding only required reserves of 10%, the money multiplier
is 1/.10 = 10. Because reserves are $100 billion, the money supply is 10 x
$100 billion = $1,000 billion.
b. If the required reserve ratio is raised to 20%, the money multiplier
declines to 1/.20 = 5. With reserves of $100 billion, the money supply
would decline to $500 billion, a decline of $500 billion. Reserves would be
unchanged.
Chapter 29: P&A-12 (page: 661)
Assume that the reserve requirement is 20%. Also assume that banks do
not hold excess reserves and there is no cash held by public. The Federal
Reserve decides that it wants to expand the money supply by $40 million
dollars.
a. If the Fed is using open-market operations, will it buy or sell bonds?
b. What quantity of bonds does the Fed need to buy or sell to accomplish
the goal? Explain your reasoning.
ANSWER:
a. To expand the money supply, the Fed should buy bonds.
b. With a reserve requirement of 20%, the money multiplier is 1/0.20 = 5.
Therefore to expand the money supply by $40 million, the Fed should buy
$40 million/5 = $8 million worth of bonds.
Chapter 29: P&A-13 (page: 661)
The economy of Elmendyn contains 2,000 $1 bills.
a. If people hold all money as currency, what is the quantity of
money?
b. If people hold all money as demand deposits and banks maintain
100 percent reserves, what is the quantity of money?
c. If people hold equal amounts of currency and demand deposits
and banks maintain 100 percent reserves, what is the quantity of
money?
d. If people hold all money as demand deposits and banks maintain
a reserve ratio of 10 percent, what is the quantity of money?
e. If people hold equal amounts of currency and demand deposits
and banks maintain a reserve ratio of 10 percent, what is the
quantity of money?
Chapter 29: P&A-13 (page: 661)-cont.
a.
b.
c.
d.
e.
ANSWER:
If people hold all money as currency, the quantity of money is $2,000.
If people hold all money as demand deposits at banks with 100% reserves, the
quantity of money is $2,000.
If people have $1,000 in currency and $1,000 in demand deposits, the quantity of
money is $2,000.
If banks have a reserve ratio of 10%, the money multiplier is 1/.10 = 10. So if
people hold all money as demand deposits, the quantity of money is 10 x $2,000 =
$20,000.
If people hold equal amounts of currency (C) and demand deposits (D) and the
money multiplier for reserves is 10, then two equations must be satisfied:
(1) C = D, so that people have equal amounts of currency and demand deposits;
and (2) 10 x ($2,000 – C) = D, so that the money multiplier (10) times the number
of dollar bills that are not being held by people ($2,000 – C) equals the amount of
demand deposits (D). Using the first equation in the second gives 10 x ($2,000 – D)
= D, or $20,000 – 10D = D, or $20,000 = 11 D, so D = $1,818.18. Then C =
$1,818.18. The quantity of money is C + D = $3,636.36.
Chapter 30: QfR-1 (page: 685)
Explain how an increase in the price level affects the
real value of money.
ANSWER:
An increase in the price level reduces the real value
of money because each dollar in your wallet now
buys a smaller quantity of goods and services.
Chapter 30: QfR-2 (page: 685)
According to the quantity theory of money, what is
the effect of an increase in the quantity of money?
ANSWER:
According to the quantity theory of money, an
increase in the quantity of money causes a
proportional increase in the price level.
Chapter 30: QfR-3 (page: 685)
Explain the difference between nominal and real variables,
and give two examples of each.
According to the principle of monetary neutrality, which
variables are affected by changes in the quantity of money?
ANSWER:
Nominal variables are those measured in monetary units,
while real variables are those measured in physical units.
Examples of nominal variables include the prices of goods, wages,
and nominal GDP.
Examples of real variables include relative prices (the price of one
good in terms of another), real wages, and real GDP.
According to the principle of monetary neutrality, only nominal
variables are affected by changes in the quantity of money.
Chapter 30: QfR-4 (page: 685)
In what sense is inflation like a tax? How does thinking about
inflation as a tax help explain hyperinflation?
ANSWER:
Inflation is like a tax because everyone who holds money loses
purchasing power.
In a hyperinflation, the government increases the money
supply rapidly, which leads to a high rate of inflation.
Thus the government uses the inflation tax, instead of taxes,
to finance its spending.
Chapter 30: QfR-5 (page: 685)
According to the Fischer effect, how does an increase in the
inflation rate affect the real interest rate and the nominal
interest rate?
ANSWER:
According to the Fisher effect,
an increase in the inflation rate raises the nominal interest
rate by the same amount that the inflation rate increases,
with no effect on the real interest rate.
Chapter 30: QfR-6 (page: 685)
What are the costs of inflation? Which of these costs do you think
are most important for the U.S. economy?
ANSWER:
The costs of inflation include shoeleather costs associated with reduced money
holdings,
menu costs associated with more frequent adjustment of prices, increased
variability of relative prices,
unintended changes in tax liabilities due to nonindexation of the tax code,
confusion and inconvenience resulting from a changing unit of account, and
arbitrary redistributions of wealth between debtors and creditors.
With a low and stable rate of inflation like that in the United States, none of these
costs are very high.
Perhaps the most important one is the interaction between inflation and the tax
code, which may reduce saving and investment even though the inflation rate is
low.
Chapter 30: QfR-7 (page: 685)
If inflation is less than expected, who benefits—
debtors or creditors? Explain.
ANSWER:
If inflation is less than expected, creditors benefit
and debtors lose.
Creditors receive dollar payments from debtors that
have a higher real value than was expected.
Chapter 30: P&A-1 (page: 686)
Suppose that changes in bank regulations expand the availability of credit cards, so
that people need to hold less cash.
a. How does this event affect the demand for money?
b. If the Fed does not respond to this event, what will happen to the price level?
c. If the Fed wants to keep the price level stable, what should it do?
ANSWER:
a. If people need to hold less cash, the demand for money shifts to the left,
because there will be less money demanded at any price level.
b. If the Fed does not respond to this event, the shift to the left of the demand for
money combined with no change in the supply of money leads to a decline in the
value of money (1/P), which means the price level rises, as shown in Figure 1.
Figure 1
Chapter 30: P&A-1 (page: 686)-cont.
ANSWER:
c. If the Fed wants to keep the price level stable, it should reduce the money
supply from S1 to S2 in Figure 2. This would cause the supply of money to shift to
the left by the same amount that the demand for money shifted, resulting in no
change in the value of money and the price level.
Figure 2
Chapter 30: P&A-2 (page: 686)
It is often suggested that the Federal Reserve try to
achieve zero inflation. If we assume that velocity is
constant, does this zero-inflation goal require that
the rate of money growth equal zero? If yes, explain
why. If no, explain what the rate of money growth
should equal.
ANSWER:
With constant velocity, reducing the inflation rate to
zero would require the money growth rate to equal
the growth rate of output, according to the quantity
theory of money (M x V = P x Y ).
Chapter 30: P&A-3 (page: 686)
Suppose that this year’s money supply is $500 billion, nominal GDP is $10 trillion, and real
GDP is $5 trillion.
a. What is the price level? What is the velocity of money?
b. Suppose that velocity is constant and the economy’s output of goods and services rises by
5 percent each year. What will happen to nominal GDP and the price level next year if the Fed
keeps the money supply constant?
c. What money supply should the Fed set next year if it wants to keep the price level stable?
d. What money supply should the Fed set next year if it wants inflation of 10 percent?
ANSWER:
In this problem, all amounts are shown in billions.
a.
Nominal GDP = P x Y = $10,000 and Y = real GDP = $5,000, so P = (P x Y )/Y =
$10,000/$5,000 = 2.
Because M x V = P x Y, then V = (P x Y )/M = $10,000/$500 = 20.
b.
If M and V are unchanged and Y rises by 5%, then because M x V = P x Y, P must fall by
5%. As a result, nominal GDP is unchanged.
c.
To keep the price level stable, the Fed must increase the money supply by 5%,
matching the increase in real GDP. Then, because velocity is unchanged, the price level will be
stable.
d.
If the Fed wants inflation to be 10%, it will need to increase the money supply 15%.
Thus M x V will rise 15%, causing P x Y to rise 15%, with a 10% increase in prices and a 5% rise
in real GDP.
Chapter 30: P&A-5 (page: 686)
Hyperinflations are extremely rare in countries
whose central banks are independent of the rest
of the government. Why might this be so?
ANSWER:
Hyperinflations usually arise when governments
try to finance much of their expenditures by
printing money.
This is unlikely to occur if the central bank (which
is responsible for controlling the level of the
money supply) is independent of the
government.
Chapter 30: P&A-6 (page: 686)
Let’s consider the effects of inflation in an economy composed only
of two people: Bob, a bean farmer, and Rita, a rice farmer. Bob and
Rita both always consume equal amounts of rice and beans. In
2008, the price of beans was $1, and the price of rice was $3.
a. Suppose that in 2009 the price of beans was $2 and the price of
rice was $6. What was inflation? Was Bob better off, worse off, or
unaffected by the changes in prices? What about Rita?
b. Now suppose that in 2009 the price of beans was $2 and the
price of rice was $4. What was inflation? Was Bob better off, worse
off, or unaffected by the changes in prices? What about Rita?
c. Finally, suppose that in 2009 the price of beans was $2 and the
price of rice was $1.50. What was inflation? Was Bob better off,
worse off, or unaffected by the changes in prices? What about Rita?
d. What matters more to Bob and Rita—the overall inflation rate or
the relative price of rice and beans?
Chapter 30: P&A-6 (page: 686)-cont.
ANSWER:
a.
When the price of both goods doubles in a year, inflation is 100%. Let’s set the market
basket equal to one unit of each good. The cost of the market basket is initially $4 and
becomes $8 in the second year. Thus, the rate of inflation is ($8 − $4)/$4 × 100% = 100%.
Because the prices of all goods rise by 100%, the farmers get a 100% increase in their
incomes to go along with the 100% increase in prices, so neither is affected by the change in
prices.
b.
If the price of beans rises to $2 and the price of rice rises to $4, then the cost of the
market basket in the second year is $6. This means that the inflation rate is ($6 − $4) / $4 ×
100% = 50%. Bob is better off because his dollar revenues doubled (increased 100%) while
inflation was only 50%. Rita is worse off because inflation was 50% percent, so the prices of
the goods she buys rose faster than the price of the goods (rice) she sells, which rose only
33%.
c.
If the price of beans rises to $2 and the price of rice falls to $1.50, then the cost of the
market basket in the second year is $3.50. This means that the inflation rate is ($3.5 − $4) /
$4 × 100% = -12.5%. Bob is better off because his dollar revenues doubled (increased 100%)
while prices overall fell 12.5%. Rita is worse off because inflation was -12.5%, so the prices of
the goods she buys didn't fall as fast as the price of the goods (rice) she sells, which fell 50%.
d.
The relative price of rice and beans matters more to Bob and Rita than the overall
inflation rate. If the price of the good that a person produces rises more than inflation, he
or she will be better off. If the price of the good a person produces rises less than inflation,
he or she will be worse off.
Chapter 30: P&A-9 (page: 686)
Recall that money serves three functions in the economy. What are those
functions? How does inflation affect the ability of money to serve each of these
functions?
ANSWER:
The functions of money are to serve as a medium of exchange, a unit of account,
and a store of value.
Inflation mainly affects the ability of money to serve as a store of value, because
inflation erodes money's purchasing power, making it less attractive as a store of
value.
Money also is not as useful as a unit of account when there is inflation, because
stores have to change prices more often and because people are confused and
inconvenienced by the changes in the value of money.
In some countries with hyperinflation, stores post prices in terms of a more stable
currency, such as the U.S. dollar, even when the local currency is still used as the
medium of exchange.
Sometimes countries even stop using their local currency altogether and use a
foreign currency as the medium of exchange as well.
Chapter 30: P&A-10 (page: 686)
Suppose that people expect inflation to equal 3 percent, but in fact prices rise by 5 percent.
Describe how this unexpectedly high inflation rate would help or hurt the following:
a. the government
b. a homeowner with a fixed-rate mortgage
c. a union worker in the second year of a labor contract
d. a college that has invested some of its endowment in government bonds
ANSWER:
a.
Unexpectedly high inflation helps the government by providing higher tax revenue and
reducing the real value of outstanding government debt.
b.
Unexpectedly high inflation helps a homeowner with a fixed-rate mortgage because
he pays a fixed nominal interest rate that was based on expected inflation, and thus pays a
lower real interest rate than was expected.
c.
Unexpectedly high inflation hurts a union worker in the second year of a labor
contract because the contract probably based the worker's nominal wage on the expected
inflation rate. As a result, the worker receives a lower-than-expected real wage.
d.
Unexpectedly high inflation hurts a college that has invested some of its endowment
in government bonds because the higher inflation rate means the college is receiving a lower
real interest rate than it had planned. (This assumes that the college did not purchase
indexed Treasury bonds.)
Chapter 30: P&A-11 (page: 687)
Explain one harm associated with unexpected inflation that is not
associated with expected inflation. Then explain one harm associated with
both expected and unexpected inflation.
ANSWER:
The redistribution from creditors to debtors is something that happens
when inflation is unexpected, not when it is expected.
The problems that occur with both expected and unexpected inflation
include shoeleather costs associated with reduced money holdings, menu
costs associated with more frequent adjustment of prices, increased
variability of relative prices, unintended changes in tax liabilities due to
nonindexation of the tax code, and the confusion and inconvenience
resulting from a changing unit of account.
Chapter 30: P&A-12 (page: 687)
Explain whether the following statements are true, false, or uncertain.
a. “Inflation hurts borrowers and helps lenders, because borrowers must pay a
higher rate of interest.”
b. “If prices change in a way that leaves the overall price level unchanged, then no
one is made better or worse off.”
c. “Inflation does not reduce the purchasing power of most workers.”
ANSWER:
a.
The statement that "Inflation hurts borrowers and helps lenders, because
borrowers must pay a higher rate of interest," is false. Higher expected inflation
means borrowers pay a higher nominal rate of interest, but it is the same real rate
of interest, so borrowers are not worse off and lenders are not better off. Higher
unexpected inflation, on the other hand, makes borrowers better off and lenders
worse off.
b.
The statement, "If prices change in a way that leaves the overall price level
unchanged, then no one is made better or worse off," is false. Changes in relative
prices can make some people better off and others worse off, even though the
overall price level does not change. See problem 7 for an illustration of this.
c.
The statement, "Inflation does not reduce the purchasing power of most
workers," is true. Most workers' incomes keep up with inflation reasonably well.
to be continued…